Wednesday, April 20, 2016

Risk - Systematic and Unsystematic Risk

Risk and its various types
Risk may be described as variability/fluctuation/deviation of actual return from expected return from a given asset/investment. Higher the variability, greater is the risk. In other words, the more certain the return from an asset, lesser is the variability and thereby lesser is the risk.
Types of Risks: The risk of a security can be broadly classified into two types such as systematic risk and unsystematic risk:
Systematic Risk: Systematic Risk refers to that portion of total variability (risk) in return caused by factors affecting the prices of all securities. Economic, political, and sociological changes are the main sources of systematic risk. Though it affects all the securities in the market, the extend to which it affects a security will vary from one security to another. Systematic risk can not be diversified. Systematic risk can be measured in terms of Beta (β), a statistical measure. The beta for market portfolio is equal to one by definition. Beta of one (β=1), indicates that volatility of return on the security is same as the market or index; beta more than one (β>1) indicates that the security has more unavoidable risk or is more volatile than market as a whole, and beta less than one (β<1) indicates that the security has less systematic risk or is less volatile than market.
Unsystematic risk: Unsystematic Risk refers to that portion of total risk that is unique or peculiar to a firm or an industry, above and beyond that affecting securities markets in general. Factors like consumer preferences, labour strikes, management capability etc. cause unsystematic risk (variability of returns) for a company’s stock. Unlike systematic risk, the unsystematic risk can be reduced/avoided through diversification. Total risk of a fully diversified portfolio equals to the market risk of the portfolio as its specific risk becomes zero.

There are differences between the systematic and unsystematic risk though they are risk. Here are some of the differences presented:
Systematic Risk
Unsystematic Risk
This type of risk affects over all securities in a market.
This type of risk is unique to a security or a company.
This risk is dependent of political or economic factors.
This risk is independent of political or economic factors.
It is also known as Market Risk.
It is also known as Diversifiable Risk.
This risk arises from management inefficiency, unsuccessful planning etc.
It occurs due to imbalance in the political situation or fluctuation in the market etc.
It can be reduced by holding large number of securities.
It can be reduced by holding better portfolios of company’s securities.

Sources of systematic risk
The main constituents of systematic risk include- market risk, interest rate risk and purchasing power risk:
a)      Market risk: The price of a stock may fluctuate widely within a short span of time even though earnings remain unchanged. The causes of this phenomenon are varied, but it is mainly due to a change in investors’ attitudes towards equities in general, or toward certain types or groups of securities in particular. Variability in return on most common stocks that is due to basic sweeping changes in investor expectations is referred to as market risk. The reaction of investors to tangible as well as intangible events causes market risk. Expectations of lower corporate profits in general may cause the larger body of common stocks to fall in price. Investors are expressing their judgement that too much is being paid for earnings in the light of anticipated events. The basis for the reaction is a set of real, tangible events– political, social, or economic.
b)      Interest-rate risk: The risk of variations in future market values and the size of income, caused by fluctuations in the general level of interest rates is referred to as interest-rate risk. The basic cause of interest-rate risk lies in the fact that, as the rate of interest paid on Indian government securities rises or falls, the rates of return demanded on alternative investment vehicles, such as stocks and bonds issued in the private sector, rise or fall. In other words, as the cost of money changes for risk-free securities, the cost of money to risk-prone issuers will also change.
c)       Purchasing-power risk: Purchasing-power risk refers to the uncertainty of the purchasing power of the money to be received. In simple terms, purchasing-power risk is the impact of inflation or deflation on an investment. Rising prices on goods and services are normally associated with what is referred to as inflation. Falling prices on goods and services are termed deflation. Both inflation and deflation are covered in the all-encompassing term purchasing-power risk. Generally, purchasing-power risk has come to be identified with inflation (rising prices); the incidence of declining prices in most countries has been slight. The anticipated purchasing power changes manifest themselves on both bond and stocks.
Sources of Unsystematic risk
a)      Business risk: Business risk relates to the variability of the sales, income, profits etc., which in turn depend on the market conditions for the product mix, input supplies, strength of competitors, etc. The business risk is sometimes external to the company due to changes in government policy or strategies of competitors or unforeseen market conditions. They may be internal due to fall in production, labour problems, raw material problems or inadequate supply of electricity etc. The internal business risk leads to fall in revenues and in profit of the company, but can be corrected by certain changes in the company’s policies.
b)      Financial Risk: This relates to the method of financing, adopted by the company; high leverage leading to larger debt servicing problems or short-term liquidity problems due to bad debts, delayed receivables and fall in current assets or rise in current liabilities. These problems could no doubt be solved, but they may lead to fluctuations in earnings, profits and dividends to share holders. Sometimes, if the company runs into losses or reduced profits, these may lead to fall in returns to investors or negative returns. Proper financial planning and other financial adjustments can be used to correct this risk and as such it is controllable.
c)       Default or insolvency risk: The borrower or issuer of securities may become insolvent or may default, or delay the payments due, such as interest instalments or principal repayments. The borrower’s credit rating might have fallen suddenly and he became default prone and in its extreme form it may lead to insolvency or bankruptcies. In such cases, the investor may get no return or negative returns. An investment in a healthy company’s share might turn out to be a waste paper, if within a short span, by the deliberate mistakes of Management or acts of God, the company became sick and its share price tumbled below its face value.
d)      Other Risks: Besides the above described risks, there are many more risks, which can be listed, but in actual practice, they may vary in form, size and effect. Some of such identifiable risks are the Political Risks, Management Risks and Liquidity Risks etc. Political risk may occur due to the changes in the government, or its policy shown in fiscal or budgetary aspects, changes in tax rates, imposition of controls or administrative regulations etc. Management risks arise due to errors or inefficiencies of management, causing losses to the company. Marketability liquidity risks involve loss of liquidity or loss of value in conversions from one asset to another say, from stocks to bonds, or vice versa. Such risks may arise due to some features of securities, such as callability; or lack of sinking fund or Debenture Redemption Reserve fund, for repayment of principal or due to conversion terms, attached to the security, which may go adverse to the investor. All the above types of risks are of varying degrees, resulting in uncertainty or variability of return, loss of income, and capital losses, or erosion of real value of income and wealth of the investor. Normally the higher the risk taken, the higher is the return.
Can risk be avoided?
Every investor wants to guard himself from the risk. This can be done by understanding the nature of the risk and careful planning.
1) Market Risk Protection
a.       The investor has to study the price behaviour of the stock. Usually history repeats itself even though it is not in perfect form. The stock that shows a growth pattern may continue to do so for some more period. The Indian stock market expects the growth pattern to continue for some more time in information technology stock and depressing conditions to continue in the textile related stock. Some stocks may be cyclical stocks. It is better to avoid such type of stocks. The standard deviation and beta indicate the volatility of the stock.
b.      The standard deviation and beta are available for the stocks that are included in the indices. The National Stock Exchange News bulletin provides this information. Looking at the beta values, the investor can gauge the risk factor and make wise decision according to his risk tolerance.
c.       Further, the investor should be prepared to hold the stock for a period of time to reap the benefits of the rising trends in the market. He should be careful in the timings of the purchase and sale of the stock. He should purchase it at the lower level and should exit at a higher level.
2) Protection Against Interest Rate Risk
a.       Often suggested solution for this is to hold the investment sells it in the middle due to fall in the interest rate, the capital invested would experience tolerance.
b.      The investors can also buy treasury bills and bonds of short maturity. The portfolio manager can invest in the treasury bills and the money can be reinvested in the market to suit the prevailing interest rate.
c.       Another suggested solution is to invest in bonds with different maturity dates. When the bonds mature in different dates, reinvestment can be done according to the changes in the investment climate. Maturity diversification can yield the best results.
3) Protection Against Inflation
a.       The general opinion is that the bonds or debentures with fixed return cannot solve the problem. If the bond yield is 13 to 15 % with low risk factor, they would provide hedge against the inflation.
b.      Another way to avoid the risk is to have investment in short-term securities and to avoid long term investment. The rising consumer price index may wipe off the real rate of interest in the long term.
c.       Investment diversification can also solve this problem to a certain extent. The investor has to diversify his investment in real estates, precious metals, arts and antiques along with the investment in securities. One cannot assure that different types of investments would provide a perfect hedge against inflation. It can minimise the loss due to the fall in the purchasing power.
4) Protection Against Business and Financial Risk
a.       To guard against the business risk, the investor has to analyse the strength and weakness of the industry to which the company belongs. If weakness of the industry is too much of government interference in the way of rules and regulations, it is better to avoid it.
b.      Analysing the profitability trend of the company is essential. The calculation of standard deviation would yield the variability of the return. If there is inconsistency in the earnings, it is better to avoid it. The investor has to choose a stock of consistent track record.

c.       The financial risk should be minimised by analysing the capital structure of the company. If the debt equity ratio is higher, the investor should have a sense of caution. Along with the capital structure analysis,. he should also take into account of the interest payment. In a boom period, the investor can select a highly levered company but not in a recession.

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